Business Investment and Innovation

This document is the second in a series of papers compiling tax reform options that Finance Committee members may wish to consider as they work towards reforming our nation’s tax system. This compilation is a joint product of the majority and minority staffs of the Finance Committee with input from Committee members’ staffs. The options described below represent a non-exhaustive list of prominent tax reform options suggested by witnesses at the Committee’s 30 hearings on tax reform to date, bipartisan commissions, tax policy experts, and members of Congress. For the sake of brevity, the list does not include options that retain current law. The options listed are not necessarily endorsed by either the Chairman or the Ranking Member.

Members of the Committee have different views about how much revenue the tax system should raise and how tax burdens should be distributed. In particular, Committee members differ on the question of whether any revenues raised by tax reform should be used to lower tax rates, reduce deficits, or some combination of the two. In an effort to facilitate discussion, this document sets this question aside.

CURRENT CHALLENGES AND POTENTIAL GOALS FOR REFORM

Under current law, businesses determine their taxable income using a complex set of rules that, in many cases, differs from the rules they use to calculate their financial or “book” income. Financial income is the measure of income that businesses are required to compute each year for financial accounting purposes, and it follows the generally accepted accounting principles (GAAP) or some other form of financial accounting. Taxable income is the measure of income they must compute in paying their taxes.

These differences between taxable income and financial income reflect the different objectives of tax policy and the accounting rules. Financial accounting rules are designed to paint a picture of a business's absolute and relative financial performance. The tax rules should be designed to equitably and efficiently collect revenue. In addition, while some disagree with this practice, the tax rules are often used to promote other policy objectives, such as incentivizing certain economic behaviors that policymakers consider socially valuable.

As a consequence of these special accounting rules and incentives embedded in the tax code, businesses spend large amounts of time and resources every year trying to calculate their tax liability. Tax reform provides an opportunity to simplify these provisions and, if members of Congress decide tax incentives are desirable, make those tax incentives more effective. This paper discusses options for reforming the rules regarding business investment, tax accounting, and innovation, with special attention to smaller businesses. Following are some potential broad principles for reform in this area:

Simplify the law in order to reduce the cost to businesses of complying with the tax code

Make the tax code more neutral by eliminating or reducing differences in effective tax rates across industries and business activities

If policy makers choose to include incentives in a reformed tax code, ensure that those incentives are effective and efficient

Provide businesses with greater certainty

Some specific concerns about the taxation of business investment and innovation include the following:

Overall complexity: Current law provides numerous tax expenditures for businesses. Tax expenditures are provisions in the tax code that deviate from a “normal” income tax. While the definition of a tax expenditure is inherently subjective, the Treasury Department and the Joint Committee on Taxation (JCT) have both published different lists of what they define as tax expenditures since 1968 and 1972, respectively. According to JCT, there are over 140 business tax expenditures in the tax code today. Among businesses with 20 employees or less, tax compliance costs $1,584 per employee, according to a 2011 Small Business Administration study. (JCS-1-13; Small Business Association, Frequently Asked Questions)

Large differences in effective tax rates by industry: Tax expenditures create large disparities in the tax treatment of different types of business investment, which may distort investment choices. According to the Treasury Department, the average federal corporate tax rate varies from a low of 14% for utilities to 31% for construction. Other studies have shown wide disparities in the taxation of different asset types. (President’s Framework for Business Tax Reform, February 2012; CRS, Corporate Tax Reform: Issues for Congress, Dec. 26, 2012)

Uncertainty created by temporary provisions: The tax code has been amended more than 15,000 times since 1986 (President’s Economic Recovery Advisory Board’s Report on Tax Reform Options, August 2010). Over 60 tax provisions expire in 2013. The temporary nature of expiring tax provisions makes it difficult for business taxpayers to plan. For example, the research and development (R&D) credit has been extended at least 15 times since 1981. The Section 179 limitations on the amount of property that can be immediately expensed, which were increased retroactively at the beginning of this year, have changed at least 7 times since 2002.

Increasing international competition in innovation: The U.S. faces increasing competition in maintaining its R&D base. Some are also concerned about increasing international competition in specific industries, such as manufacturing. Others believe the tax code should not favor one business sector over another. Most of our major trading partners are enhancing the benefits they offer for R&D to entice companies to locate R&D centers in their countries, with the associated high paying jobs. For example, China, India, Brazil, the UK, Ireland, Singapore, Australia, Russia, and France have recently increased their tax incentives for R&D. According to the Organisation for Economic Cooperation and Development (OECD), in 2008, U.S. R&D tax incentives ranked 24th out of 38 developed countries surveyed. (OECD Science, Technology, and Industry Scoreboard 2009) On the other hand, the OECD found that for 2009, the United States was second in total government subsidies for R&D as a percentage of GDP, looking at both direct subsidies and tax incentives. (OECD Science, Technology, and Industry Scoreboard 2011)

Limited business effect of tax incentives that defer tax liability: Some tax incentives allow businesses to pay tax later than it would otherwise be due. Such timing changes do not affect the nominal amount of taxes due, although they can be very valuable due to the time value of money. For example, accelerating depreciation deductions means that a business pays less tax in the years immediately following the purchase of an asset, but pays correspondingly more tax later in the useful life of the asset. Many publicly-traded corporations and certain private businesses often plan with a focus on financial income. In general, changes in the timing of paying a tax do not impact financial income and, as a result, may not significantly affect business behavior. Therefore, to incentivize business behavior, it may be more effective to provide tax incentives that are not timing-based, but instead are, for example, rate reductions or credits.

REFORM OPTIONS

I. SMALLER BUSINESSES

There is no agreed-upon definition of what constitutes a small business. For example, JCT has identified at least 42 different definitions of a small business or small employer in the tax code. Nevertheless, there are several provisions of current law that could be targeted for reform as they apply to small businesses (although some think the definition of a small business in these rules is overinclusive or underinclusive):

Section 179 expensing: Under Section 179, businesses can immediately expense certain property, such as equipment or machinery, instead of depreciating the property. The maximum amount that can be expensed is $500,000 for 2013. This amount is phased out once qualifying property exceeds $2,000,000. In 2014, the maximum amount will become $25,000, phasing out at $200,000.

Cash method of accounting: Under current law, generally certain businesses with average annual gross receipts under $5 million can report their income and expenses (other than inventory) using a cash method rather than an accrual method. The same is true of certain farming businesses and personal service businesses. Taxpayers using a cash method generally report income when they receive it and deduct expenses when paid. Taxpayers using an accrual method generally report income when all events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. Accrual method taxpayers deduct expenses when all events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has taken place.

Inventory accounting: If the production, purchase or sale of goods is an income-producing factor for a business, then the business is required to use inventory accounting for the goods.The rules for deducting the costs of inventory vary depending on whether the costs are direct or indirect. For direct costs, businesses that earn income from inventory are required to “capitalize” (meaning not immediately deduct) the costs of inventory that they produce or purchase, and then recover the costs when the goods are sold. In addition, with very few exceptions, businesses with inventory are required to use the accrual method of accounting for inventory. For indirect costs of inventory, businesses that produce their own inventory are typically subject to an additional set of rules—the so-called uniform capitalization (“uni-cap”) rules—which require them to capitalize indirect costs associated with producing inventory. In contrast, businesses that purchase their inventory for resale are not subject to the uni-cap rules unless they have average annual gross receipts exceeding $10 million.

Research and development credits: As an incentive to encourage innovation, businesses can claim a credit for incremental spending on labor and supplies used for research. This credit is non-refundable. This means that businesses are only entitled to claim the credit to the extent that they have sufficient income tax liability to offset. If they do not, such credits may be carried back one year and carried forward 20 years.

Start-up and organizational expenditures: The first $5,000 of start-up and organizational expenditures incurred in the context of starting a new business may generally be expensed, subject to a phase-out of such immediate deduction if such expenses exceed $50,000. Expenditures that do not qualify to be immediately expensed can be amortized (i.e., deducted) over a period of 15 years.

Section 1202 stock: As an incentive to encourage investment in start-up businesses, non-corporate taxpayers may generally exclude 50% of the gain from selling “qualified small business stock” that was acquired at original issue and held for more than 5 years (100% through 2013). The exclusion is limited to stock of a C corporation whose gross assets do not exceed $50 million (and that meets certain active business requirements).

Passive activity loss rules: The passive activity loss rules prevent taxpayers from using losses from certain passive investments to offset their taxable income from other sources, such as salary income. If a taxpayer has a net loss from passive investments for the year, that loss is carried forward and is available to offset any income from passive sources that the taxpayer reports in future years.

Following are potential reform options for smaller businesses related to these provisions:

A. Expand cash method accounting and, potentially, expensing through one of the following options:

i. Allow smaller businesses with, for example, up to $10 million in gross receipts to use a “business cash flow tax” model. In such a system, all business cash receipts are immediately included as income and all business cash disbursements are immediately deductible as expenses. Accordingly, the purchase of inventory, equipment, buildings and even land are immediately deductible. Such a system completely eliminates the need to account for inventories and depreciate business property (President’s Advisory Panel on Tax Reform, 2005)

A. Exempt R&D-focused pass-through entities from the passive activity loss rules to help them raise capital (S.3595 and H.R.6559, …to provide an exception from the passive loss rules for investments in high technology research small business pass-thru entities, sponsored by Sen. Menendez and Rep. Gerlach)

Under current law, businesses generally cannot immediately expense the cost of tangible property used in their business, but rather must “capitalize” the cost of such property and recover it over time through depreciation deductions. The same is true of intangible property, although deductions in that case are called “amortization.”

The Tax Reform Act of 1986 introduced the current modified accelerated cost recovery system (MACRS) for computing depreciation. The cost of property is depreciated over its applicable recovery period, which is based on designated “class lives”. Such recovery periods are generally shorter than the economic life of the asset. Some assets, such as buildings, are depreciated in equal amounts over the recovery period of the asset (straight-line depreciation). Other assets, such as equipment, are depreciated more quickly over the recovery period of the asset (e.g., the double declining balance method). In general, intangible assets (for example, goodwill and patents) are amortized on a straight-line basis over 15 years. However, certain expenditures for intangible assets, such as advertising, are deducted in the year paid or incurred even though they may create value that lasts beyond the current year.

In addition to the normal MACRS rules, an alternative depreciation system (ADS) was also enacted in 1986 for certain limited purposes. Taxpayers can elect to use ADS, in place of MACRS, as their regular depreciation method. Under ADS, property is depreciated over longer periods than MACRS using the straight-line method. Many of the class lives and asset classifications for MACRS and ADS have not been updated since the 1980s.

Following are potential reform options for depreciation and amortization:

1. Revise the depreciation rules for tangible assets to more closely track their economic lives through one of the following reforms:

Under current law, businesses can deduct up to 9% (6% for oil and gas businesses) of their income from domestic manufacturing and production (Section 199). By its nature, this provision reduces the marginal and average tax rate of certain businesses.

2. Target or simplify the domestic production deduction through some or all of the following reforms:

A. Limit the deduction to manufacturing and industries that can relocate abroad, for example by disallowing the deduction for some or all of the following: film, utilities, construction, engineering and architectural services, natural resource extraction and agriculture (President’s Framework for Business Tax Reform, February 2012)

C. Provide a larger deduction for income from advanced manufacturing activities, such as activities that depend on information, automation, computation, software, sensing, or networking, or for cutting-edge technology (President’s Framework for Business Tax Reform, February 2012; proposal by Sen. Brown)Provide the same percentage deduction for all domestic production activities, including oil and gas (Merrill Matthews, About Those Tax Breaks for Big Oil . . ., Wall St. J. A17, April 3, 2013)

IV. INNOVATION

Under current law, businesses can choose to immediately expense R&D costs or amortize such costs over 5 years or more. In addition, businesses can claim a nonrefundable credit for incremental spending on labor and supplies used for research. Businesses can choose between two forms of the R&D credit: (1) the “traditional” credit, which is calculated by comparing current research expenses to those between 1984 and 1988, and (2) the “alternative simplified credit,” which is calculated by comparing current research expenses from the past three years. The R&D credit has always been temporary and currently expires at the end of 2013. It is often difficult for businesses to successfully claim the credit for all their research activities because of the complex rules regarding what activities or costs qualify for the credit.

D. Disallow supplies from definition of research expenses (Michael Rashkin in his addendum to his testimony at Senate Finance hearing on Tax Reform Options: Incentives for Innovation on September 20, 2011)

Inventory. Under current law, businesses generally may not deduct the cost of goods in inventory until the inventory is sold. Businesses can elect one of several methods for deciding which specific inventory item is deemed to be sold, which matters when items of the same good were purchased at different prices. Under first-in, first-out (FIFO), the business deducts the cost of goods in the order in which they were acquired. Under last-in, first-out (LIFO), the business deducts the cost of the most recently acquired goods first. Under weighted average, the business deducts the average cost of goods available for sale during the period, while under specific identification, the business deducts the cost of the specific product being sold. If prices rise over time, LIFO accounting results in less taxable income. If a business adopts LIFO accounting for tax purposes, it must also use LIFO for financial accounting purposes. The International Financial Reporting Standards, which are used in many foreign jurisdictions, do not permit LIFO accounting.

In addition to picking the method of calculating inventory (e.g., LIFO, FIFO, etc.), taxpayers must also pick a method of valuing inventory. There are three methods for valuing inventory: cost, the lower of cost or market and retail pricing.

Like-kind exchanges. In some circumstances, taxpayers are allowed to defer gains on business or investment property when it is traded for similar property. In addition to permitting direct swaps of property, current law allows certain “three-cornered transactions” in which taxpayers can use intermediaries to facilitate the acquisition of similar property. If, however, a taxpayer sells property and reinvests the proceeds in similar property outside of the like-kind exchange rules, the taxpayer must pay tax immediately on the sale even though the end result is the same.

Insurance. Insurance companies are generally taxed as corporations, except that the reserves they hold to meet policyholder obligations or pay claims are deductible when established rather than when the claim is paid. The tax code permits this deduction in recognition of the fact that insurance companies take premiums into income when they are received, while the related claim may not be paid for years.

The tax code contains numerous rules regarding the computation of the reserve deduction. While insurance companies use their state-mandated reserves as the starting point for determining the amount of their reserve deduction, they must make adjustments to that starting point. For example, they have to adjust for the time value of money if there is a delay in paying claims, and for the benefit of funding reserves with tax-preferred income. Many aspects of these adjustments are classified by JCT as tax expenditures.

The rules governing insurance taxation have not been significantly reformed since 1986. Since then, many more insurance companies have become publicly traded. The federal government has become more active in overseeing the financial solvency of insurance companies through the Treasury Department’s Federal Insurance Office and Dodd-Frank. And technology has enabled insurance actuaries to more accurately predict long-term liabilities. Many of the options listed below involve revisiting insurance taxation in light of these developments.

1. Repeal last-in, first-out (LIFO) inventory accounting through one of the following options: